Where Bank of England Policymakers Are Seeking Future Guidance

November 19, 2008

Minutes from the Monetary Policy Committee’s (MPC) early-November meeting candidly reveal that policymakers believed that they would ultimately need to cut rates by more than 200 basis points from the 4.5% level but were reluctant do more than 150 basis points until markets better understand their thinking and the factors upon which future near-term policy will hinge. The Committee therefore voted 9-0 to reduce the Bank Rate to 3.0%. Today’s minutes are an important part of the communication process that prepares markets for future rate reductions.

The MPC worried that a larger rate cut in November, just one month after they cut rates by 50 bps, “might be misinterpreted as a change in their reaction function, which would damage the credibility of the inflation target.” It was deemed important for the public to see the Bank’s November Inflation Report, which revised projected consumer price inflation down by a record increment. Inflation targeting remains an anchor of policy, and the new assessment predicts that medium-term inflation would be lower than the 2.0% objective if the Bank Rate stays at 3.0% in the period.

Three factors are then cited as areas that will guide the near-term course of monetary policy after November.

  • The Labour government presents its pre-budget statement on November 24th. It was not clear to the MPC how much new stimulus it would contain, the composition of that support, and the market’s reaction to the fiscal plans.
  • Banking system strains in the U.K. and elsewhere had begun to subside when the MPC met two weeks ago, but policymakers wanted to see how the healing progressed and, even more importantly, how money and credit growth respond to the more stable financial environment.
  • The behavior of sterling will be seen a litmus test for market trust in the dramatically looser monetary policy and faith in future price stability. Officials expected sterling to depreciate in the wake of the 150-bp rate cut and the markedly worse indications of prospects for U.K. economic activity. Since November 6, sterling has fallen 4.4% against the dollar, 3.0% against the euro, and 4.4% on a trade-weighted basis. Empirical work done more than a decade ago by the central bank equated the impact of a 4% change in the trade-weighted exchange rate to that of a 100-basis point change in short-term interest rates. Officials understandably did not quantify a tolerance limit for sterling depreciation, so it is unclear if the pound’s loss was within the expectation of officials or excessive. I doubt officials were surprised by the size of sterling’s recent drop.

A fourth reason for not cutting the Bank Rate by more than 150 basis points is the powder-dry argument. The MPC wants to retain leeway to cut interest rates in response to future turns for the worse in economic activity. The recession in Britain will stretch out to late-2009, and a return to positive growth will not be confirmed until 2010. Bank officials hope to lend support as needed during this long downturn. It is striking how united MPC members have been, voting unanimously for both its rate cuts in October and November. The previous nine votes had dissents. Some of the reason for not cutting rates more deeply in November was to have more time to communicate policy, which they have now done, and to make sure that sterling, with its history of crises, didn’t collapse, which it hasn’t. Contingent on no compelling developments to the contrary occurring in the coming two weeks, no reason exists for officials not to cut rates again in December, and that drop is likely to exceed 25 basis points.

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